Health Savings Accounts: A Primer, by Jennifer R. Noel*

In the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, Congress permitted the creation of Health Savings Accounts (“HSAs”) by adding section 223. In Notice 2004-50 and Rev. Rul. 2005-25, the Service

provided further guidance on the requirements and administration of HSAs. Most recently, in the Health Opportunity Patient Empowerment Act of 2006 (included in

the Tax Relief and Health Care Act of 2006), Congress significantly expanded the attractiveness of HSAs. The discussion below is based on the law in effect following

the 2006 legislative changes and includes the 2007 inflation-adjusted amounts provided in Rev. Proc. 2006-53.

Fall 2007 I 13 points to remember investment nonforfeitable T he 223 contribution HSA is covered have deductible offered 223(Certain insurance do automatically insurance falls within “insurance,” provides of an Section 223(that to worker’s or (4) tax-care costs. Taxpayers to take advantage benefits other TERMINOLO GY to expenses 223(223(creating The aggregate a year exceed 223(additional that section 223(older. of section 223. the assets ICongress creation of Health Savings (“HSAs”) 223. and Rev. the Service in the Empowerment Act of 2006 and Act Congress The discussion below is based on the law following legislative inflation-adjusted Proc. 2006-Savings Accounts: A Primer By Jennifer R. Noel* As be A lthough (1) benefits. 223(A than for single coverage due under for covered $for single coverage. other Those plans that fall from 223(insurance outof-considered services because exceeds section 223(Young LLP, DE. POINTS TO REMEMBER Health Savings Accounts: A Primer Noel* n the Medicare Prescription Drug, Improvement, and Modernization Act of liabilities as provided by regulations; (B) 2003, Congress permitted the creation of Health Savings Accounts ("HSAs") by insurance for a specific disease or illness; adding section 223. In Notice 2004-50 and Rev. Rul. 2005-25, the Service or (C) hospitalization insurance that pays a specific benefit amount based upon the provided further guidance on the requirements and administration of HSAs. Most time spent hospitalized. As noted above, recently, in the Health Opportunity Patient Empowerment Act of 2006 (included in an eligible individual may be covered by the Tax Relief and Health Care Act of 2006), Congress significantly expanded the permitted insurance in addition to a high attractiveness of HSAs. The discussion below is based on the law in effect follow-deductible health plan. ing the 2006 legislative changes and includes the 2007 inflation-adjusted amounts Although they might otherwise qualify provided in Rev. Proc. 2006-53. as eligible individuals, two groups of taxpayers cannot deduct contributions to HSAs: (1) individuals who are claimed as HSAs are attractive because taxpayers can must not be commingled with any other dependents on the tax return of another, deduct contributions to them and later property unless they are invested in a and (2) individuals entitled to Medicare withdraw funds tax-free to pay for current common trust fund or a common invest-bene ts. Section 223(b)(6)-(7). and future medical care costs. Taxpayers ment fund. Fifth, the trust document must A high deductible health plan is one who wish to take advantage of these ben-provide that the individual has a nonfor-that (1) has an annual deductible of not efits must understand HSA terminology, feitable right to the account balance. less than $1,100 for single coverage and deduction amounts, and other rules. The section 223 deduction for a con-(2) provides that the sum of the annual tribution to an HSA is available only to an deductible and all other out-of-pocket TERMINOLOGY eligible individual. An eligible individual expenses due under the plan, other than An HSA is a trust, created in the United is any individual who is covered under a the premiums, for covered benefits does States, to pay the qualified medical ex-high deductible health plan as of the first not exceed $5,500 for single coverage. penses of the account beneficiary. day of a month. As a general rule, the Both single coverage amounts are doubled Section 223(d). Section 223(d)(3) individual must not have other health for family coverage, which is defined defines account beneficiary as the insurance coverage that is provided as any coverage other than self-only individual on whose behalf the HSA was through a plan that is not a high deduct-coverage. Those plans that fall within created. The governing instrument creat-ible health plan and that would provide the definition of permitted insurance, or ing the trust must meet five requirements. overlapping coverage for any benefit of-provide coverage for accidents, disability, First, contributions, other than rollover fered by the high deductible health plan. dental care, vision care, or long-term care, contributions, must be in cash and are Section 223(c)(1). Certain types of insur-are excluded from the definition of a high subject to dollar limitations. The aggregate ance coverage, however, do not automati-deductible health plan. Section 223(c)(2). contributions for a year cannot exceed cally disqualify an individual from being For insurance plans that provide both the sum of the maximum annual amount eligible to fund an HSA. If the other insur-a network of providers and benefits for allowed for family coverage set forth in ance coverage falls within the definition services provided by out-of-network section 223(b)(2)(B) and any annual ad-of "permitted insurance," or if it provides providers, the annual deductible for outditional contribution amount that section coverage for accidents, disability, dental of-network services will not be consid-223 (b)(3) allows for individuals who are care, vision care, or long-term care, it will ered for purposes of determining whether 55 and older. Second, the trustee must be not make an individual ineligible for the the plan is a high deductible health plan. a bank, an insurance company, or some purposes of an HSA. Section 223(c)(3) As a result, the annual out-of-pocket other person able to demonstrate to the divides permitted insurance into three limitations for out-of-network services satisfaction of the Service that the trust categories: (A) coverage that substantially will not cause a plan to fail to qualify as will be administered consistently with the relates to (1) worker's compensation a high deductible health plan because requirements of section 223. Third, none injuries, (2) tort liabilities, (3) injuries the limitation exceeds the maximum of the trust assets may be invested in life occurring as the result of the ownership sum to be paid as provided in section insurance contracts. Fourth, the assets or use of specific property, or (4) similar 223 (c)(2)(D)(i). *Young Conaway Stargatt & Taylor, LLP Wilmington, DE. FALL 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=65e96ee4-f864-40d7-a9a1-3e27f49893e114 I Section of Taxation NewsQuarterly Health Savings Accounts I Points to remember can deduct amounts contributed adjusted gross HSAs In affect taxpayers’ related 223(tax ceases qualified subject tax on unrelated 223(on taxpayer respect contributions. has established of he or determined coverage of the lesser inflationadjusted individual inflationadjusted monthly limitation If the individual has the inflation-For taxable the Health Opportunity Patient be treated individual from for taxable years for taxable and thereafter. The following HSA and of $1,500, for the HSA per If the deductible to $per year, the maximum or $237.50 December 2007, permitted this per month. T he is reduced 220 the same year. amount any individual Archer outlined above. provides coverage, to HSAs. to sections Contributions provided 223(223 regard to any community property laws 223(custodial 223 account be appropriately 223(E). EMPLO YER d)(4)(C) refers sections f)(5) regarding contributions HSA. Section employee’s 223(219(provides apply, the employee’s in contribution regard AND ROLLOV ERS are medical expenses 213(important established beneficiary’s can deduct contributions to and later withdraw care costs. HEALTH SAVINGS ACCOUNTS I POINTS TO REMEMBER TAX DEDUCTION Taxpayers can deduct amounts contribut-Taxpayers can deduct contributions to HSAs and later withdraw ed to HSAs in computing adjusted gross income. The ability to fund HSAs on a funds tax-free to pay for current and future medical care costs. pre-tax basis is one of their attractions. n addition, contributions to HSAs do not afect taxpayers' ability to contribute ing example explains how these rules later than the date on which the income to tax-favored retirement vehicles, thus operate. If an individual has a single tax return for such taxable year is due, allowing taxpayers to accumulate funds coverage HSA and a high deductible excluding extensions therefor, pursuant for the future payment of health-related health plan with a deductible of $1,500, to sections 223(d)(4)(B) and 219(f)(3). expenses as well as retirement. Section the monthly limitation for the HSA would Section 223 is to be applied without 223 (e) provides that an HSA is exempt be $125 per month. If the deductible to from income tax unless it ceases to be is increased to $3,000 per year, the pursuant to section 223(d)(4)(D). A cusqualified as an HSA or it becomes sub-monthly limitation for 2007 would be todial account may be treated as a trust ject to the section 511 tax on unrelated one-twelfth of $2,850, the maximum for purposes of section 223 provided that business income. permitted, or $237.50 per month. If the the account is held by a bank or another Section 223(b) imposes limitations individual is an eligible individual for person who demonstrates that the acon contributions the taxpayer may make ecember 2007, the maximum permit-count will be appropriately administered, to an HSA and amounts the taxpayer ted contribution and deduction amounts pursuant to section 223(d)(4)(E). may deduct with respect to those con-would be the full $1,500 or $2,850. If tributions. The general rule is that an the individual is 55 or older, the monthly EMPLOYER CONTRIBUTIONS individual who has established an HSA limitation is increased by one-twelfth of Section 223(d)(4)(C) refers to sections may deduct an amount equal to the sum the additional contribution amount. In 106(d) and 219(f)(5) regarding contribuof the monthly limitations for the months 2007, this is one-twelfth of $800, or tions by an employer to an HSA. Section during which he or she is an eligible $66.67 per month. 106(d) provides that if an employee is an individual. The monthly limitation is de-The monthly limitation is reduced eligible individual, a contribution made by termined based upon whether the eligible by any amounts paid to a section 220 an employer to the employee's HSA will individual has single or family coverage Archer MSA on behalf of the individual be treated as employer-provided coverage under a high deductible health plan, or contributed to another HSA for the for medical expenses under a qualified and will equal one-twelfth of the lesser individual in the same year. Thus, the plan, as long as the amounts contributed of the annual deductible or the inflation-aggregate amount any individual may do not exceed the limitations set forth in adjusted monthly limitation. If the indi-contribute to one or more HSAs or Ar-section 223(b). Section 219(f)(5) providual has single coverage, the inflation-cher MSAs and deduct for tax purposes vides that if section 106(d) does not apadjusted monthly limitation for 2007 is limited to the amounts outlined above. ply, employer contributions to an HSA are is $2,850. If the individual has family Section 223(b)(5) provides additional treated as compensation to the employee, coverage, the inflation-adjusted monthly limits for married individuals. If either includible in the employee's gross income limitation for 2007 is $5,650. For tax-spouse maintains family coverage, both for the taxable year in which the contribuable years beginning after December 31, spouses are treated as having such tion is made, without regard to whether 2006, the Health Opportunity Patient family coverage, with the lower of the the employee is entitled to a deduction for Empowerment Act has increased the two deductibles, if the two plans provide the payment under section 219. potential deduction. A taxpayer who is an for different deductibles. The monthly eligible individual during the last month deduction limitation is divided equally DISTRIBUTIONS AND ROLLOVERS of the taxable year will be treated as between the two spouses unless they Distributions from an HSA that are used having been an eligible individual during agree on a different division. to pay qualified medical expenses (as each month of that year. Section 223(b) Certain additional rules apply to HSAs. defined in section 213 (d)) are excluded (8). Individuals who turn 55 before the No deduction is available for rollover from the gross income of the account end of the taxable year may contribute contributions pursuant to sections beneficiary. One important limitation and deduct an additional amount, which 223(d)(4)(A) and 219(d)(2). Contribu-applies: the HSA must be established increases from $700 for taxable years tions are deemed to be made on the last before a medical expense is incurred in beginning in 2006 to $1,000 for taxable day of the preceding taxable year, pro-order for such expense to be reimbursed years beginning in 2009 and thereafter. vided they are made on account of that from the HSA and excluded from the The 2007 amount is $800.The follow-preceding taxable year and are made not beneficiary's gross income. ABA SECTION OF TAXATION NEWSQUARTERLY Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=65e96ee4-f864-40d7-a9a1-3e27f49893e1Fall 2007 I 15 Points to remember I Health Savings Accounts A mounts will beneficiary’s beneficiary that exceed contributions the beneficiary’s contribution The returned gross income contribution. the excess beneficiary. 4973 imposes an T he additional expenses. The excise becomes disabled eligibility. 223(receives days the date of receipt, be treated contribution beneficiary’s date distribution on April 15, 16, cannot be treated as HSA. beneficiary the designated beneficiary’s interest the account ceases medical reasons. recipient’s beneficiary’s the deceased beneficiary’s beneficiary’s if beneficiary’s the gross is reduced the estate taxes HSA’s decedent’s PLA NS Patient spending January 1, 2012, causing the FSA That act also added section trusteeto-beneficiary’s HSA engages the account cease termination, deemed be treated engaging in a prohibited transaction beneficiary. 223(medical with percent CONCLU SION HSAs funding care expenses healthrelated taxpayer’s gross income. particularly contributions medical expense 7.5% tax). planning n POINTS TO REMEMBER I HEALTH SAVINGS ACCOUNTS Amounts that are withdrawn from Special rules apply for divorce and TERMINATION an HSA but are not used for qualified death. A transfer of an interest in an HSA If the beneficiary of an HSA engages in medical expenses will be included in the that is made pursuant to divorce is not a prohibited transaction as defined in beneficiary's gross income. If a benefi-treated as a taxable event. The spouse section 4975, the account will cease ciary contributes amounts that exceed who receives the interest is treated as to qualify as an HSA as of the first day the annual contribution limits, but such having an HSA. When an account ben-of the year in which the prohibited excess contributions are returned before eficiary dies, the HSA may be handled transaction occurs. Upon such terminathe due date of the beneficiary's income in one of two ways. If the designated tion, the account is deemed to have tax return for the year of contribution, beneficiary is the surviving spouse of the been distributed to the beneficiary. An the excess is not treated as a contribu-original account beneficiary, the HSA will account created by an individual and tion or as a distribution. The returned be treated as if the surviving spouse had an account created by an employer for amount itself is neither included in gross been the original account beneficiary. If the same individual will be treated as ncome as a distribution for non-medical someone other than the surviving spouse two separate accounts. The effect of purposes nor deductible as an HSA con-receives the deceased beneficiary's inter-tribution. The net income attributable est in the account, the account ceases to will apply only to the account that was to the excess contribution must also be be an HSA as of the date of death. The directly affected. If the beneficiary of an distributed with the excess contribution. account is then deemed to have been HSA uses the account as security for a The returned net income is included in distributed for non-medical reasons. loan, that portion of the account that gross income of the account beneficiary. The amount is included in the recipient's was used as security will be deemed to If an excess contribution is made to gross income if the recipient is not the have been distributed to the beneficiary. an HSA and is not distributed from beneficiary's estate. The account is The deemed distributions provided for the HSA to the beneficiary prior to the included in the deceased beneficiary's in section 223 (e)(2) are treated as above deadline, section 4973 imposes gross income for the beneficiary's amounts not used for qualified median additional six percent tax on the last taxable year if the recipient of the cal expenses, with the result that such excess contribution. account is the beneficiary's estate. If the deemed distributions will be subject to The beneficiary will be subject to an deceased beneficiary incurred qualified income tax and the additional ten peradditional excise tax equal to ten percent medical expenses prior to death that cent excise tax discussed above. of any distributions that are not used for were paid after death from the HSA, the qualified medical expenses. The excise amount included in the gross income of CONCLUSION tax will not be imposed if a distribution the recipient of the account is reduced The availability of HSAs provides an is made after the beneficiary becomes by those payments. A recipient who attractive planning opportunity for funddisabled or dies, or after the beneficiary must include the amount of the HSA in ing future health care costs. Individuals has reached the age for Medicare eligi-gross income can deduct the estate taxes using HSAs can set funds aside on a bility. Section 223 (f)(4). attributable to the HSA's inclusion in the pre-tax basis for health care expenses If an account beneficiary receives a decedent's gross estate. that may be incurred at any point distribution from an HSA and, within following the creation of the account. 60 days following the date of receipt, DISTRIBUTIONS TO HSAs FROM Funds contributed to the HSA grow on contributes the funds to a new HSA, OTHER PLANS a tax-deferred basis. Distributions, both those funds will be treated as a rollover The Health Opportunity Patient before and after retirement, for healthcontribution and will not be included in Empowerment Act added section 106(e) related expenses are excluded from the the beneficiary's gross income. An HSA to cover distributions from flexible spend-taxpayer's beneficiary may make only one rollover ing accounts and health reimbursement High-income individuals may find during any one-year period, ending on the accounts to HSAs. One such distribution HSAs particularly attractive because condate that is one year after the date can be made before January 1, 2012, tributions to HSAs are not subject to the of receipt of the previous rollover distribu-without causing the FSA or HRA to lose section 213 medical expense deduction tion from an HSA. In other words, if an its status for purposes of sections 105 limitations, pursuant to which deductible individual receives a distribution from an and 106. That act also added section medical expenses are limited to those HSA on April 15, 2007, and rolls it into 408(d)(9) to allow a limited trustee-that exceed 7.5% of AGI (and 10% of another HSA, any further distribution from to-trustee transfer from an individual AGI for the alternative minimum tax). an HSA for non-medical reasons prior to retirement plan to an HSA. Only one As a result, HSAs may be a useful plan-April 16, 2008, cannot be treated as a such tax-free transfer may be made in ning tool available to individuals with the rollover contribution to an HSA. the beneficiary's lifetime. ability to create and fund them. FALL 2007 Document hosted at http://www.jdsupra.com/post/documentViewer.aspx?fid=65e96ee4-f864-40d7-a9a1-3e27f49893e1

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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